A banner year for hedge funds

NEW YORK (Fortune) -- It looks like risk is back. The hedge fund industry had a phenomenal 2009, with a return of 18.6%, for its greatest rebound in 15 years, says a report from industry research firm Credit Suisse Tremont.

Even though net asset flows for the year were negative, investors poured in $13.8 billion in new money in the fourth quarter, the largest quarterly inflow since the height of the hedge fund boom, according to Hedge Fund Research, which tracks fund performance.

And all this just one year after Lehman Brothers filed for bankruptcy and only months after the market bottomed out in March. It was a far cry from 2008, when investors pulled about $99 billion from the hedge fund space and the industry as a whole fell 19.5% in the second half of the year alone, according to Credit Suisse Tremont.

"In many respects, 2009 was essentially the reverse of the financial crisis of 2008," says Ken Heinz, president of HFR. His firm estimates that hedge funds currently manage $1.6 trillion, which is about $300 million less than their all-time high of $1.9 trillion.

Heinz notes that many strategies that did poorly in 2008 rebounded in a big way in 2009, including convertible arbitrage, fixed income, and funds with lots of illiquid assets.

Last year's top and worst performing funds tracked by HSBC show just how much hedge fund returns vary. Senvest Partners, Turnberry Capital, and Palomino were the best performing hedge funds in 2009, with returns of 229%, 156%, and 130% respectively. The three worst performing funds were Horseman Global, Tulip Trend, and Bennelong Asia Pacific Multi Strategy, down 25%, 25%, and 21%.

Changes were also afoot last year that have made 2010 a "buyer's market" for investors hoping to put money into hedge funds, Credit Suisse Tremont wrote in its report.

Many funds were weeded out in 2009. About 2,000 were liquidated, due to poor performance or an inability to raise money, bringing the total to around 9,000, estimates HFR.

As managers tried to attract new money and appease investors who were upset over poor performance and funds that wouldn't let them take their money out, one of the first things they did was lower fees.

According to HFR, average management and incentive fees have fallen to 1.6% and 19.2% from the typical 2% on assets under management and 20% cut of the return made on investments.

Many funds reduced lock up provisions, which is Wall Street parlance for the amount of time a fund can hold your money before you can ask for it back. Big institutions and pension fund investors were able to negotiate separate managed accounts, so their assets could be kept separate from other investors in a fund, and they could withdraw money at any time.

And funds that want to bring in money from large institutions must now bow to demands for better risk management, independent administrators, and better transparency when it comes to disclosing things like investments and how a fund values an illiquid asset.

As for how investors are positioning themselves for 2010, the largest inflows at the end of last year went to long/short equity funds, managed futures funds, and credit, distressed, and high-yield strategies.

"The reality is, there wasn't a lot of volatility last year and many asset prices had been severely dislocated and undervalued at the beginning of 2009," says Heinz. "Without those factors, it will be very difficult to make money in 2010. Investors are returning to hedge funds, but it won't be an easy year."